Setting The Stage for The Next Collapse

When the central bank pumps money into the economy and suppresses interest
rates it creates incentives to speculate and invest in ways that would not
otherwise be viable. At a superficial level the central bank's strategy will
often seem valid, because the increased speculating and investing prompted
by the monetary stimulus will temporarily boost economic activity and could
lead to lower unemployment. The problem is that the diversion of resources
into projects and other investments that are only justified by the stream of
new money and artificially low interest rates will destroy wealth at the same
time as it is boosting activity. In effect, the central bank's efforts cause
the economy to feast on its seed corn, temporarily creating full bellies while
setting the stage for severe hunger in the future.

We witnessed a classic example of the above-described phenomenon during 2001-2009,
when aggressive monetary stimulus introduced by the US Federal Reserve to mitigate
the fallout from the bursting of the NASDAQ bubble and "911" led to booms in
US real estate and real-estate-related industries/investments. For a few years,
the massive diversion of resources into real-estate projects and debt created
the outward appearance of a strong economy, but a reduction in the rate of
money-pumping eventually exposed the wastage and left millions of people unemployed
or under-employed. The point is that the collapse of 2007-2009 would never
have happened if the Fed hadn't subjected the economy to a flood of new money
and artificially-low interest rates during 2001-2005.

Rather than learning from prior mistakes, that is, rather than learning from
the fact that the use of monetary stimulus to mitigate the effects of the 2000-2002
collapse led to a more serious collapse during 2007-2009 and a "lost decade" for
the US economy, the 2007-2009 collapse became the justification for the most
aggressive monetary stimulus to date. The damage wrought by previous attempts
to artificially stimulate has resulted in the pace of economic activity remaining
sluggish despite the aggressive monetary accommodation of the past several
years, but it is still not difficult to find examples of the mal-investment
that has set the stage for the next collapse. Here are some of them:

1) The suppression of interest rates has prompted a scramble for yield, which
has pushed yields on higher-risk bonds down relative to yields on lower-risk
bonds. The bonds issued by the governments of Spain and Italy now yield only
slightly more than US Treasury Notes, the yields on investment-grade corporate
bonds are now roughly the same as the yields on equivalent government bonds,
and the yields on junk bonds are generally much lower than normal relative
to the yields on investment-grade corporate bonds. This tells us that monetary
accommodation has greatly increased the general appetite for risky investments,
which is always a prelude to substantial losses.

2) Public companies have been buying back equity at a record pace, despite
high equity valuations. One reason is that although equity valuations are high,
debt is generally priced even higher. Regardless of how expensive a company's
stock happens to be, from a financial-engineering perspective it can make sense
for the company to borrow money to repurchase its own stock as long as the
interest rate on its debt is lower than its earnings yield. Buying back stock
boosts per-share earnings and often increases bonus payments to management,
but it does nothing to expand or improve the underlying business.

3) The number of unprofitable IPOs during the first half of this year was
the highest since the first half of 2000. What a waste.

4) The latest boom has been so obviously reliant on the Fed's easy money that
the real economy's response has been far less vigorous than usual. This at
least partly explains the reticence of corporate America to devote money to
capital expenditure designed to grow the business and, instead, to focus on
financial engineering designed to give per-share earnings a boost. IBM provides
us with an excellent example. As David Stockman points out in a recent blog
post, since 2004 IBM has generated $131B of net income, spent $124B buying-back
its own stock and devoted $45B to capital expenditure. IBM has therefore been
channeling almost all of its earnings into stock buy-backs and has bought back
almost $3 of its own stock for every $1 of capex. Furthermore, 90% of the capex
was to cover depreciation and amortisation. No wonder IBM has just reported
declining year-over-year revenue for the 9th quarter in succession.

If interest rates were at more realistic levels there would be less incentive
to buy back stock and more incentive to invest in ways to increase productivity.

5) Thanks to the combination of government support, low interest rates and
a flood of new money, some large, poorly-run companies are staggering around
like zombies, consuming resources that could have been used more productively.
General Motors is a prime example.

6) On an economy-wide basis there has been no deleveraging in the US. This
is evidenced by the following chart. Instead, the Fed's promotion of leveraged
speculation and the government's deficit-spending maintained the steep upward
trend in economy-wide credit. Consequently, in terms of total debt the US economy
is in a more precarious position today than it was in 2007. It will therefore
not be possible for interest rates to normalise without precipitating an economic
collapse.

7) The abundance of cheap credit prompted hedge funds and private equity firms
to buy more than 200,000 US houses, which in many cases are now being rented
to people who lost their homes when the previous Fed-promoted boom turned to
bust. This has boosted house prices and created the false impression that the
residential real-estate market is immersed in a sustainable recovery, prompting
new (mal-) investments in this market.

8) The strength in auto sales is linked to the ready availability of subprime
credit, which, in turn, is an effect of central-banking largesse, making it
likely that auto sales will tank within the next two years. This will not only
affect the assemblers of cars and the manufacturers of the components that
go into cars, but will also affect all the industries that are involved in
the shipping, storage, selling and financing of new cars.

9) While there is no doubt that the shale oil-and-gas industry would have
been a great success story without the flood of cheap credit engineered by
the Fed, the flood of cheap credit has led to a massive increase in the industry's
debt-to-revenue ratio that has probably made the economics of shale-oil production
look better than is actually the case and made the industry acutely vulnerable
to tighter monetary conditions. Consequently, despite its solid economic foundation
there will probably be many bankruptcies within this industry over the next
few years.

A final point is that just as you never really know who has been swimming
naked until after the tide goes out, you will never be able to identify all
the mal-investments until after the monetary stimulus comes to an end.